Korean activist fund mired in controversy over SM stock deals

A South Korean private equity firm leading shareholder activism against SM Entertainment Co. is mired in controversy as it has surfaced that it sold its shares in the K-pop pioneer and then lent them to short sellers for a fee.

Align Partners Capital Management Inc. founder and CEO Lee Chang-hwan sold his stake in SM through his own company in March of this year to take profit but advised other shareholders to maintain their stakes for the long term with a pledge to support SM’s growth through new governance, according to investment banking industry sources.

The activist fund also made profits by providing all of its shares in SM for loans to short sellers right after HYBE Co., the label behind the global sensation BTS, decided to give up its face-off with Kakao Corp. for control of SM with an estimated $1 billion price tag, putting pressure on its share prices.

“They were legitimate management strategic decisions,” said an official at Align Partners, but those transactions have been criticized as they are seen to contradict the PE firm’s vows to improve shareholder value.

SELLING SHARES HELD BY LEE’S OWN COMPANY

Lee sold all of the 10,000 stocks of SM he held through his own company Align Holdings in March when the stock prices faced significant volatility due to a fierce battle between HYBE and Kakao for the entertainment agency.

SM’s share prices hit a record high of 161,200 won ($120.10) on March 8 but lost ground after HYBE announced a withdrawal from the bid on March 12.

“We sold the shares after March 14 when the disappointment on the end of the competition between HYBE and Kakao was already priced in,” Lee said. The stocks closed at 115,200 won on the day.

He was estimated to enjoy about a 100% return with the sale as Align Holdings reportedly bought SM stocks at an average of 50,000 won per share.

Lee recommended SM to shareholders as a long-term investments when HYBE and Kakao fiercely fought for the label behind the girl group aespa. He said he would not participate in Kakao’s tender offer, expecting SM's share price to surge to 300,000 won in the next two years.

LOAN TRANSACTIONS FOR SHORT SELLERS

Align Partners also earned money by lending SM stocks to short sellers.

The PE firm signed a loan transaction deal to lend all of the 220,000 SM stocks it held through a prime Samsung Securities Co. brokerage service for about a month from March 14 to receive a fee of 770 million won, about 30% the total per annum value of those stocks, which was far higher than industry practice. Align Partners also lent 48,000 SM shares it held for its own proprietary trading through NH Investment & Securities Co.

Stocks borrowed through loan transactions are used as collateral to secure loans but also often for short selling. Hedge funds and other short sellers usually borrow stocks for investment or a trading strategy that speculates on a share's decline through securities firms' prime brokerage services as it is hard to borrow the targeted stocks one by one.

Securities firms set the fees for loan transactions depending on market forces or business relationships with asset managers. Major domestic brokerage houses usually pay fees of about 1% to individual shareholders and fees in the high-teens to some institutional investors.

Align Partners enjoyed higher-than-usual fees for the loan transactions as demand for short selling surged after the end of the takeover battle. SM stocks lost about 17% during the contracts.

“The loan transactions were to maximize profits of funds in order to fulfill the duty of care and liability for limited partners (LPs),” Lee said. “We could have faced a breach of trust issue from LPs unless we took action to raise the returns from SM since we committed to long-term investments.”

Align Partners collected all of the SM stocks earlier this month to hold them, Lee added.

The PE firm also said those loan transactions have no legal issues since the deals were inked after HYBE announced the decision to draw back from the acquisition of SM.

PENNY WISE, POUND FOOLISH

Investment banking industry sources, however, said the transactions went against Align Partners’ pledge to maximize shareholder value.

“Activist funds can make money through loan transactions with stocks they hold, but few funds do so,” said an official at an activist fund management firm. “That’s like penny wise and pound foolish while betraying shareholders who are aligned with the activism.”

Align Partners significantly undermined its own shareholder activism campaign, industry sources said.

It initially secured shareholders’ support to raise SM’s enterprise value with pledges of improving corporate governance by checking major shareholders. The PE firm, however, later helped short sellers, which built up bearish bets on SM.

“It is understandable for a hedge fund to seek every means for profit within the legal framework, but Align was in the spotlight as the first successful activist fund in South Korea,” said an investment banking industry source.

“Align should have seriously considered how individual shareholders, who agreed with Align’s vision, would have interpreted these transactions.”

Write to Jun-Ho Cha at chacha@hankyung.com
 
Jongwoo Cheon edited this article.